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Estimating the cost of capital: a technical appendix for the economic regulation of Heathrow and Gatwick from April 2014: Notices of the proposed licences

CAP 1140

CAP 1140

Estimating the cost of capital: a technical appendix for the economic regulation of Heathrow and Gatwick from April 2014: Notices of the proposed licences

© Civil Aviation Authority 2014

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CAP 1140 Table of Contents

January 2014 1

TABLE OF CONTENTS

Chapter 1: Summary .......................................................................................... 2

Chapter 2: Introduction ....................................................................................... 4

Chapter 3: Methodological issues ...................................................................... 5

Chapter 4: Estimating the WACC: summary .................................................... 10

Chapter 5: Estimating the WACC: gearing and the cost of debt ....................... 17

Chapter 6: Estimating the WACC: cost of equity .............................................. 34

Chapter 7: Estimating the WACC: conclusions ................................................ 47

CAP 1140 Chapter 1: Summary

January 2014 2

CHAPTER 1

Summary

1.1 The CAA has decided to use a pre-tax real1 weighted average cost of

capital (WACC) of 5.35% for Heathrow Airport Limited (HAL) and

5.7% for Gatwick Airport Limited (GAL) for Q6.

1.2 The CAA’s final views are lower than the CAA’s October 2013 final

proposals of 5.60% and 5.95% respectively because of a lower cost of

equity resulting from a lower total market return (TMR) assumption. In

coming to these final views the CAA has considered further

stakeholder responses and new evidence in the form of the

Competition Commission's (CC) provisional determination on Northern

Ireland Electricity (NIE).

1.3 The WACCs for both airport operators have reduced compared to the

Q5 settlement2 of 6.2% for HAL and 6.5% for GAL. The reductions

mainly reflect reductions in corporate tax, the cost of debt and TMR

since the previous settlement (2008/9 to 2013/14).

Approach

1.4 The CAA's approach to the WACC continues to assume notionally

financed airport operators. The financing structure should remain the

responsibility of the regulated company. The regulated companies

and their shareholders should bear the risk of highly leveraged

structures (or gearing above the notional gearing assumptions).

1.5 The CAA assumes gearing (debt to regulatory asset base (RAB)) of

60% for HAL (Q5: 60%) and 55% for GAL (Q5: 60%).

1.6 Throughout the review, the CAA’s approach was a combination of a

careful assessment of the individual components of the WACC and a

1 All figures in this document are expressed in pre-tax real (i.e. inflation adjusted) terms unless

otherwise stated. 2 The Q5 headline WACC was 6.2% (HAL) and 6.5% (GAL), but the figures applied to the RAB

to derive the actual capital charge were reduced to 6.01% and 6.3% respectively owing to the

airport operators’ ability to reinvest returns within the year. A similar automatic adjustment has

not been made for Q6; instead the concept has been taken into account as one of the factors

when deciding the point estimates within the range.

CAP 1140 Chapter 1: Summary

January 2014 3

top-down assessment of the WACC. Evidence was taken in the round

by the CAA to reach its proposals for the point estimates for the

WACC.

Cost of equity

1.7 The cost of equity is estimated using the Capital Asset Pricing Model

(CAPM). The post-tax cost of equity estimate for HAL and GAL has

been reduced compared to the final proposals to reflect the lower

TMR assumption. The beta assumptions are unchanged. As a

consequence the post-tax cost of equity is 6.8% for HAL and 7.0% for

GAL. The lower TMR assumption reflects the new evidence

presented by the CC and the greater emphasis placed by the CC on

forward-looking estimates (which tend to be lower than the very long-

run historical estimates).

1.8 The CAA continues to consider that it is not appropriate to include a

specific uplift for skewed equity returns, something for which HAL had

argued.3

Cost of debt

1.9 The CAA's cost of debt assumption, 3.2% for both HAL and GAL, is

unchanged from the final proposals. Several stakeholders considered

that the CAA had made errors in its calculation. The CAA has

assessed the responses and notes that although there is some

evidence to suggest that the appropriate assumption might be lower

or higher than 3.2%, on balance the evidence available suggests an

estimate of 3.2% is appropriate.

3 HAL considered that similar to other investments it suffers in recessions but, relative to other

investments, it cannot benefit when the economy is doing well owing to capacity constraints.

CAP 1140 Chapter 2: Introduction

January 2014 4

CHAPTER 2

Introduction

2.1 This document sets out the CAA’s reasoning for its assessments of

the WACCs to apply to the Q6 price settlements for HAL and GAL.

Unless otherwise stated this document refers to the pre-tax real

WACC.

2.2 This document should be read in conjunction with the Economic

regulation at Heathrow from April 2014: notice of the proposed licence

(CAP 1138) and Economic regulation at Gatwick from April 2014:

notice of the proposed licence (CAP 1139), both published at the

same time and available from the CAA’s website.

2.3 The remainder of this document is structured as follows.

Chapter 3 considers methodological issues including whether

adjustments need to be made for skewed equity returns and

whether it is appropriate to introduce debt indexation.

Chapter 4 sets out the overarching comments received.

Chapter 5 assesses gearing and the appropriate value for the cost

of debt.

Chapter 6 assesses risk and the appropriate value for the cost of

equity.

Chapter 7 draws together the preceding chapters and assesses the

appropriate WACC value.

CAP 1140 Chapter 3: Methodological issues

January 2014 5

CHAPTER 3

Methodological issues

3.1 This chapter considers the basic framework, skewed equity returns

and debt indexation.

Basic framework

WACC and CAPM

3.2 The final proposals concluded that, consistent with previous reviews

and other regulated sectors, the WACC was the appropriate basis for

estimating the cost of capital and that the two elements were the cost

of equity (using the CAPM framework) and the cost of debt. The final

proposals noted that:

HAL thought that the 'standard' CAPM should be modified or

extended to take into account 'skewed' equity returns.4 This

specific issue is discussed in more detail below.

GAL thought that its evidence suggested that its returns were more

negatively skewed than those of HAL and that this implied a greater

uplift to the CAPM-based cost of capital for GAL.

3.3 Other than in respect of skewness, the responses to the final

proposals did not suggest a departure from the WACC and CAPM

approach, and hence the CAA concludes that the WACC continues to

be the most appropriate way to assess the cost of capital and the

CAPM framework is the most appropriate way to assess the cost of

equity.

Split cost of capital

3.4 The final proposals concluded that it was not appropriate to adopt the

split cost of capital for Q6.5 The CAA did not receive any subsequent

4 Equity returns are the returns earned by shareholders in the form of dividends (income) and

share price appreciation (capital growth). 5 The split cost of capital assumes that the RAB is a long-term relatively risk-free asset, in

contrast to the development of new capital investment and the operation of the airport, which

are inherently riskier. The split cost of capital proposes that the RAB can be fully debt-funded

and should, therefore, attract a relatively low cost. The capital base required to support capital


January 2014 6

responses in favour of adopting the split cost of capital. The CAA has

decided not to adopt the split cost of capital for Q6.

Accounting rate of return

3.5 The accounting rate of return (ARR) is a concept that recognises that

within a year returns can be reinvested, and therefore to earn the

WACC by the end of the year, a lower cost of capital, the ARR, should

be applied to the RAB. The ARR was used in previous quinquennia

and is used in other, but not all, regulated sectors.

3.6 In the initial and final proposals, the CAA noted that since the WACC

was ultimately a judgement within a plausible range of outcomes,

formulaically applying the adjustment might result in spurious

accuracy. However, the CAA continued to consider that there was an

argument for the use of the concept of the ARR because returns that

are earned throughout the year can be reinvested. The CAA noted

that it was, therefore, something the CAA expected to take into

account when judging where in the range to adopt its proposals for the

WACC.

3.7 The CAA did not receive any responses in respect of its proposed

approach to the concept of the ARR. However, some airline

responses considered that contrary to what the final proposals stated,

the CAA had not taken account of the ARR in deciding the appropriate

point estimate in the range. The point estimate for the WACC taking

account of the ARR concept is discussed in chapter 7.

Skewed equity returns

3.8 Negatively skewed equity returns would mean that compared to other

investments, an airport operator has more downside risk than upside

potential. For example, the airport operator could suffer in recessions,

but not be able to benefit when the economy is doing well.6 If

expenditure and operating expenditure is riskier and should attract the cost of equity. A fuller

explanation can be found in the initial proposals. 6 The CAPM assumes that share returns have a normal distribution. This distribution is symmetric, with

equal chances of the same upside gain and downside loss. Because of this symmetry, risk can be fully

described by the standard deviation (or equivalently by the variance). Professor Ian Cooper, on behalf

of HAL, argued that when returns are not normally distributed, the CAPM is an incomplete model.

Skewness means that the upside potential of a company’s shares is different to their downside risk.

Positive skewness means that upside potential is greater than downside risk, and negative skewness

means that downside risk is greater than upside potential. In particular, Cooper argued when there is

significant skewness of returns the standard deviation (and consequently the CAPM beta) is no longer


January 2014 7

skewness exists and is material, investors with well diversified

portfolios are concerned about the coskewness of the investment

relative to the market generally.

Final proposals

3.9 The final proposals set out the representations made by HAL, GAL

and British Airways (BA), along with the advice from the CAA’s own

independent study by PricewaterhouseCoopers (PwC)7, on whether or

not the CAA should make a specific adjustment to uplift HAL’s and

GAL's cost of equity to reflect negatively skewed equity returns.

Building on the initial proposals, the final proposals concluded that

beta and coskewness were likely to be driven by the same factor

(excess demand over fixed capacity). The final proposals noted that

as a consequence, if capacity tightens one would expect the beta to

fall and negative coskewness to increase, other things being equal.

The final proposals noted that PwC estimated the risk premium for

HAL taking into account beta only (second moment CAPM) and beta

and coskewness (third moment CAPM), and concluded that this

analysis showed that the post-tax cost of equity was in a range of

4.7% to 7.3%. Because of the commonality of factors driving beta and

coskewness, there appeared, in fact, no difference in the end result.

The CAA's final proposals used a post-tax cost of equity of 7.3%,

which was at the top of this range.

3.10 The final proposals noted that PwC did not find negative coskewness

associated with the BAA asset beta above 0.45, therefore the beta

estimate proposed by the CAA of 0.5 for HAL was too high to be

associated with negative coskewness.

3.11 The CAA concluded that an adjustment for coskewness would not be

appropriate with the beta estimate. The CAA considered that there

was insufficient merit in including an allowance for skewness and

reducing the beta because PwC's estimates of the third moment

CAPM suggested that on average over the long-run it was within the

an adequate description of risk. Furthermore, Cooper argued that skewness matters because it affects

the desirability of an investment to investors and, hence, the cost of equity. Published at

http://www.caa.co.uk/default.aspx?catid=78&pagtype=90&pageid=67

7 PwC provided three reports for the CAA. These can be found at:

http://www.caa.co.uk/default.aspx?catid=78&pagetype=90&pageid=14279

http://www.caa.co.uk/default.aspx?catid=78&pagtype=90&pageid=67

http://www.caa.co.uk/default.aspx?catid=78&pagetype=90&pageid=14279


January 2014 8

margin of accuracy of the second moment CAPM and that there was

benefit in a consistent approach with previous control periods.

Responses

3.12 HAL considered that the CAA had failed to address the evidence on

the systematic asymmetry of HAL’s returns, resulting in an under

estimation of HAL’s cost of equity. HAL made reference to the papers

it had previously submitted. HAL also focused on a short period just

before de-listing in 2006 to show that an asset beta of 0.43 was

consistent with negative coskewness coefficient of -0.46 and that this

would increase the pre-tax WACC by 44 basis points (bps).

Discussion of the issues

3.13 In response to the final proposals HAL noted that for the period very

shortly before de-listing an asset beta of 0.43 (the CAA used 0.50 in

its final proposals) was consistent with negative coskewness. In the

final proposals the CAA noted this, but also noted that over a longer

period, negative coskewness was not consistent with the beta

estimate above 0.45. PwC presented 14 years' worth of monthly data,

and HAL arguments focused on a small number of data points.

Furthermore, using HAL's suggestion of an asset beta of 0.43 a

negative coskewness coefficient of -0.46 and a coskewness premium

of -1.9% the cost of equity is broadly the same as using an asset beta

of 0.5 as shown in Figure 3.1.

Figure 3.1 Post-tax cost of equity using HAL's coskewness assumptions

Component CAA's final view HAL's suggested asset beta,

coskewness coefficient and

coskewness premium

Risk-free rate 0.5% 0.5%

Asset beta 0.50 0.43

Equity beta 1.10 0.93

Equity risk premium* 5.75% 5.75%

Coskewness coefficient - -0.46

Coskewness premium - -1.9%

Post-tax cost of equity 6.83% 6.69%

* the equity risk premium (ERP) is likely to be lower where a coskewness premium is also used. For

simplicity the table uses the same ERP in both calculations.

Source: CAA calculations and page 31 of HAL's response


January 2014 9

Decision

3.14 The CAA's view is unchanged from its final proposals. The CAA does

not consider it appropriate to include an allowance for coskewness in

the cost of equity for Q6.

Indexation of the cost of debt

3.15 The CAA's cost of capital calculation includes a cost of debt

assumption. In Q5 and previous quinquennia, the cost of capital and

its components were fixed, ex-ante, for the quinquennia. An

alternative approach (called indexation) is for the cost of debt and

therefore the cost of capital to be updated in line with market

movements during the control period.8

Final proposals

3.16 The CAA proposed that, on the balance of evidence, it would not be in

passengers' interests to introduce debt indexation for the airport

operators for Q6.

Responses

3.17 No new or material comments were received.

Final view

3.18 The CAA's final view is unchanged from its final proposals.

8

The cost of equity is often considered to be a long-run estimate and relatively unmoved by

markets in the shorter run (i.e. during the control period). In contrast the cost of debt is

considered to be more dependent on short-run market conditions which can change during the

quinquennium.

CAP 1140 Chapter 4: Estimating the WACC: summary

January 2014 10

CHAPTER 4

Estimating the WACC: summary

Final proposals

4.1 The final proposals set out the representations made by stakeholders

along with the advice from PwC from its own independent study on

the appropriate estimate of the cost of capital.

Figure 4.1: Summary of the CAA’s final proposals for the WACC

HAL GAL

Gearing 60% 55%

Pre-tax cost of debt 2.78 - 3.45% 2.95 - 3.58%

Total market return 6.25 - 6.75% 6.25 - 6.75%

Risk-free rate 0.5 - 1.0% 0.5 - 1.0%

Equity risk premium 5.75% 5.75%

Asset beta (number) 0.42 - 0.52 0.46 - 0.58

Equity beta (number) 0.9 - 1.15 0.9 - 1.17

Post-tax cost of equity 5.68 - 7.61% 5.68 - 7.71%

Tax rate 20.2% 20.2%

Pre-tax cost of equity 7.11 - 9.54% 7.11 - 9.66%

Pre-tax WACC 4.51 - 5.89% 4.82 - 6.31%

CAA point estimate pre-tax WACC 5.60% 5.95%

CAA point estimate vanilla9 WACC 4.85% 5.10%

Source: CAA's final proposals

Responses

4.2 This section sets out overarching responses to issues including the

CC's NIE provisional determination. In the chapters which follow this

9 The vanilla WACC is calculated from the pre-tax cost of debt and the post tax cost of equity. It

therefore excludes any adjustment for taxation. This facilitates comparisons across sectors

(regulators take different approach to tax) and over time (when tax rates change).


January 2014 11

one, these points are explored further and the CAA's final views are

set out.

HAL

4.3 HAL commented that 'the CAA’s final proposals make a 0.25%

upward revision to HAL’s WACC to 5.6%, with the effect of providing

for a WACC that is a little closer to a rate of return that might

incentivise investment, but still falls significantly short of such a rate.

The shortfall is the result of a combination of errors and

misjudgements that fall outside of the discretion afforded to the CAA

under the [Civil Aviation] Act 2012.'

4.4 HAL considered that the CAA failed to consider the fact that there was

a global, competitive market for finance and, given such a market,

whether the return offered for investment in HAL at least meets the

opportunity cost of other options. HAL considered that investors will

manage investments relative to those alternatives and relative to the

risks, which in this instance included the regulated return. HAL

considered that in light of the regulatory risk, revenue risk and the

proposed reductions in the level of allowable return, the CAA’s

assumption that HAL should be in a position to ‘guarantee’ c£3bn of

investment during Q6 is economically irrational.

4.5 HAL also considered that the CAA’s claim that it had done a 'top-

down' analysis to check the overall reasonableness of its final

proposals on WACC was not borne out by a close examination of the

CAA’s technical analysis. HAL considered that in 93 pages, the

extent of top-down analysis was minimal and appeared to come down

to a very brief comparison of levels of WACC for other UK regulated

industries.

4.6 HAL considered it hard to understand the CAA’s claim that a

comparison between the allowed returns of UK regulated companies

showed that the WACC it proposes for HAL was fair taking into

account relative risks. HAL asserted that the CAA had provided no

analysis that would allow this conclusion to be checked. By way of

example, HAL noted that the CAA proposed a WACC 25bps below

that set in 2009 by Ofwat for water and sewerage companies. It was

unclear to HAL why such companies might be said to have

significantly higher risk, not least in the light of their certain customer

base and demand.


January 2014 12

4.7 HAL considered that the CAA took a significant risk when it dismissed

the need to take coskewness into account. HAL thought that the

CAA's two primary reasons for doing so were that PwC found 'no

conclusive proof of asymmetric risk' and that 'it was not clear' that

taking coskewness into account would ultimately change the WACC.

HAL noted that leaving aside the appropriateness of dismissing an

adjustment for asymmetric risk because of an absence of clear proof

that it is necessary, the approach taken by the CAA was

inappropriately risky as it failed to take into account whether investors

believe there to be asymmetric risk.

4.8 HAL considered that the CAA appeared to draw some comfort for its

decision on WACC for Q6 from the fact that HAL continued to invest in

Q5 with the implication that HAL regarded the CAA’s proposed WACC

for Q5 as acceptable. HAL refuted the CAA’s assertion that the

WACC during Q5 was correct or acceptable and HAL considered that

it made this clear to the CAA on a number of occasions.

4.9 HAL considered that operating under a previous price control cannot

be taken as evidence that the regulated company accepted all

elements, or as evidence that those elements could be carried forward

to the next price control without challenge. HAL believed that its

ability to raise funds to invest in the proposed capital expenditure

(capex) programme could be at risk and did not believe that the

programme and the benefits for passengers should be put at risk by a

WACC that cannot be viewed by objective investors as 'pro-

investment'.

GAL

4.10 Oxera, on behalf of GAL, noted that while there was an upwards

revision in the WACC, there were a number of important reasons why

the WACC was still too low. The most significant point was the failure

to recognise that greater competition faced by GAL should be

compensated for in a higher asset beta and a higher rate of return.

Oxera considered that it could not be reasonable for the CAA and its

advisers to accept that GAL has faced greater risk and greater

volatility of revenues, but not to allow it a higher rate of return through

a higher asset beta. Similarly, while the CAA had agreed to raise the

cost of debt allowed for in the price control there was insufficient

recognition that GAL’s cost of debt was higher than HAL’s. Oxera

considered that it was important that greater recognition be given to


January 2014 13

the higher risks faced by GAL compared with HAL and that this

difference was reflected in the asset beta and the cost of debt, and

consequently in a WACC which adequately reflected the difference in

the risk profile of the two airports. Oxera did not consider that the

proposed WACC differential between HAL and GAL of 35bps was

sufficient.

Airlines

4.11 easyJet considered that the CAA should not have increased its

estimate of GAL’s cost of capital from 5.65% to 5.95%. easyjet

considered that there were three main weaknesses in the changes

made by PwC to GAL’s estimated WACC.

easyJet considered that PwC's assessment of the cost of capital

was originally based on a top-down assessment of the overall cost

of debt and cost of equity rather than the component parts of each

of these. However, easyJet considered that the final proposals

focused on a detailed assessment of the individual component

parts.

easyJet considered that PwC's cost of debt estimates were based

on short-term measures of debt, which risk distorting the WACC

estimates by using short-term estimates rather than longer-term

estimates.

easyJet considered that PwC had artificially increased GAL’s cost

of debt to ensure that it was higher than HAL’s, despite market

evidence that GAL has a lower cost of debt than HAL.

4.12 Airport Consultative Committee – Gatwick Airport (ACC) believed that

the CAA’s estimate of the GAL WACC of 5.95% (compared with an

effective rate of 6.3% in Q5) was inaccurate in three key respects and

failed to reflect the WACC of a notionally efficient airport operator:

the cost of debt was excessive and the ACC understood the CAA

had made errors in its calculations;

the reduction of gearing to 55% and increasing beta was not based

on evidence; and


January 2014 14

the CAA was wrong to take a point at the top of the range, implying

illogically that all uncertainty was in one direction. The decision on

the range also failed to account for the CAA change of policy on

reinvestment of returns.

4.13 BA considered that the CAA had made significant errors in its

calculation of WACC and that the proposed cost of capital, at 5.6%

and 5.95% were excessive, not based on the evidence, and contrary

to passengers' interests. It was BA's view that:

the cost of debt was wrong because of methodological and

technical errors;

the CAA had selected a figure for the overall WACC that was at or

above the top end of the range proposed by PwC (rather than at

the 75th percentile as stated) because of errors in the treatment of

inflation; and

the evidence on equity beta did not support the beta assessment,

especially given the (unjustified) reduction in GAL gearing relative

to Q5.

4.14 The Heathrow Airline Community, (which comprises the London

(Heathrow) Airport Consultative Committee (LACC) and Heathrow

AOC Limited (AOC)) noted that the adjustments made to the WACC

bore little resemblance to current trends in market rates for debt and

equity. Consequently the Heathrow Airline Community could not

accept the rationale behind the proposed increase in the WACC. The

Heathrow Airline Community considered that:

Airport infrastructure and regulated assets with index-linked

revenues and regulatory asset values were attractive assets to a

broad range of investors. It considered that this was further

supported by the acquisition by USS of shares in HAL's ultimate

parent company in October 2013, after the announcement of the

final proposals, at a premium of 14% to 15% to regulatory asset

value (broker estimates).


January 2014 15

The CAA had not taken a step back to examine what the

developments in capital markets meant and what an appropriate

return for an asset provider like HAL should be. The impact of

lower bond yields and other capital market developments was

having a far larger impact on decisions made by Ofgem and Ofwat

without any detrimental impact on the supply of capital.

4.15 Virgin supported the responses of the Heathrow Airline Community

and the ACC.

CC's NIE provisional determination

4.16 In November 2013 the CC published its provisional determination of

the NIE's new price control arrangements. The CC estimated that the

vanilla WACC is 4.1% for the period from April 2012 to September

2017.

HAL

4.17 HAL commissioned NERA to review the relevance of the CC's

provisional determination for NIE for the CAA’s estimate of the cost of

capital for Q6. In summary, NERA found the CC’s decision to hold

little relevance, particularly for estimates of:

TMR - because of differences in time period to which the review

relates and concerns with the evidence base;

the cost of debt - because of the reliance on current low yields (for

new debt), the lack of allowance for fees (for embedded debt);

HAL is much riskier than NIE; and

the point estimate from the range. The CC's selection of the mid-

point (after adjusting some of its ranges) did not allow for the

asymmetric effect of incorrectly estimating the WACC or

asymmetric beta risks.

GAL

4.18 GAL raised concerns should the CAA adopt the CC's provisional NIE

determination. GAL noted that:

these were merely provisional, the CAA would need to explain what

was wrong with its own final proposals;


January 2014 16

the CAA should not be fettered by a CC decision particularly as the

Competition and Markets Authority (CMA) rather than the CC will

be the appeal body and that the provisional decision was for NIE

and does not take into account GAL specific factors; and

differences in the treatment of embedded debt as well as the cost

of equity.

Airlines

4.19 Responses from the airlines all considered that the CC's provisional

determination showed that the HAL and GAL WACCs included in the

CAA's final proposals were too high.

The airlines noted the CC used a lower TMR and ERP compared to

the CAA's final proposals.

The airlines noted that the CC's selection of a point estimate for the

WACC which represented the mid-point in the range. Some

respondents noted that this supported their previous submissions

which criticised the CAA's choice of a point estimate which was

high in the range.

Discussion of the issues and final views

4.20 The overarching responses to the issues set out in this chapter are

discussed in detail and the CAA's final views set out in the following

chapters.

CAP 1140 Chapter 5: Estimating the WACC: gearing and the cost of debt

January 2014 17

CHAPTER 5

Estimating the WACC: gearing and the cost of

debt

Gearing

Final proposals

5.1 In the initial and final proposals the CAA proposed that the appropriate

gearing should be 60% and 55% for HAL and GAL respectively. For

HAL the gearing assumption was unchanged from Q5. For GAL the

final proposal was 5% lower than Q5.

5.2 The final proposals noted that ultimately, the choice of gearing was a

matter of judgement. The CAA placed some weight on the status quo

to avoid unnecessary uncertainty. However, GAL’s relative risk

exposure was higher compared to HAL, specifically with respect to

exposure to demand risk, implying a relatively smaller capacity for

debt financing. The CAA considered that the difference in risk

between HAL and GAL warranted a lower gearing assumption for

GAL.

Responses

5.3 The ACC did not consider there was a rational basis for reducing the

gearing assumption to 55% for a notionally efficient company of GAL’s

size, while also increasing the beta. The ACC considered that this

was below GAL’s current gearing and the stated intention to GAL's

investors. The ACC also noted that the CAA/PwC analysis also found

that GAL had issued bonds in Q5 at rates lower than HAL on average

(2.9% for GAL compared to 3.3% for HAL).


5.4 The CAA continues to consider, for the reasons set out in PwC's work

and the initial and final proposals, that GAL's risk profile is such that

the appropriate gearing assumption for GAL should be slightly lower

than HAL. The cost of GAL's actual debt is lower than that of HAL

and, as noted in the final proposals, this is explained by the

differences in timing of the issuances.


January 2014 18

5.5 The CAA considers that the level of gearing in the notional capital

structure is an important assumption and input into the assessment of

financeability and ultimately whether the price cap meets the CAA's

requirements to have regard to:

the need to secure that each holder of a licence is able to finance

its provision of airport operation services; and

the need to promote economy and efficiency on the part of each

holder of a licence.

5.6 If notional gearing is too low, then the notional financial structure may

not be economic or efficient. The CAA notes that it is generally

considered that the WACC increases as gearing falls because of the

tax shield on debt.

5.7 If the notional gearing assumption is too high then the notional airport

operator might find it difficult to finance its operations. The CAA's

financeability testing in the main documents10

supports the view that

the notional airport operator will be able to finance its operations at the

assumed gearing of 60% and 55% for HAL and GAL respectively.

Furthermore, the ratios suggest that there is scope to absorb

downside shocks and maintain an investment grade rating, but that

the level of that buffer is not so large as to suggest significant

inefficiency in the assumed gearing levels.

5.8 The CAA notes that the CC's NIE provisional determination assumed

a gearing level of 50% and this suggests that the CAA's assumptions

are broadly correct.

Final views

5.9 The CAA proposes to use gearing of 60% and 55% for HAL and GAL

respectively.

Cost of debt

Final proposals

5.10 The cost of debt in the final proposals was 3.2% for HAL and GAL.

This was lower than the Q5 determination (3.55%).

10

'Economic regulation at Heathrow from April 2014: notice of the proposed licence' and

'Economic regulation at Gatwick from April 2014: notice of the proposed licence'.


January 2014 19

Figure 5.1: Cost of debt range including fees in the final proposals

HAL GAL

Historical fixed rate debt (70%) 3.30% 3.10%

New debt and floating rate debt (30%) 2.50% 2.75%

Cost of debt excluding fees 3.05% 3.00%

Fees 0.15% 0.20%

Cost of debt including fees 3.20% 3.20%

Source: Final Proposals

5.11 The CAA used a range of data and evidence to arrive at its final

proposals. The final proposals noted that while there might be a risk

differential between HAL and GAL and that theoretically this might be

reflected in the cost of debt, this was offset because GAL's actual cost

of debt is lower than HAL's. The CAA concluded that for Q6 the

gearing and beta differentials sufficiently take into account the

difference in risk.

Reponses

HAL

5.12 HAL considered that the CAA's final proposals included a combination

of errors and misjudgements which HAL estimated meant that the

CAA had understated the cost of debt by 70bps and the WACC by

42bps.


January 2014 20

Figure 5.2 'Errors and misjudgements' on the cost of debt identified by

HAL

Impact on HAL's WACC bps

Flawed model of forward market corporate debt cost 4

Omission of new issue premium from cost of new debt 4

Partial omission of revolving credit facility 13

Erroneous change to ‘mid-point’ of Q6 1

Omission of the impact of non-sterling debt 3

Arbitrary overlay to cost of debt range 4

Update to latest market yields 1

Flawed analysis of the cost of new debt 12

Total 42

Source: HAL's responses to final proposals

FLAWED MODEL OF FORWARD MARKET CORPORATE DEBT COST

5.13 HAL considered that the CAA’s estimate of the cost of new debt relies

critically on PwC’s regression analysis of the relationship between

yields on government and corporate bonds.

5.14 HAL considered that PwC’s numerical assumption for the relationship

between government gilt and corporate bond yields was unsound,

unstable and fell short of a value of 1.0 that was supported by

available analysis and evidence (ie corporate debt yields tend, on

average, to move in a one-to-one relationship with government debt).

OMISSION OF NEW ISSUE PREMIUM FROM COST OF NEW DEBT

5.15 HAL noted that the CAA had not included an explicit allowance for the

new issue premium (NIP) in the cost of debt, relying on advice from

PwC. HAL considered that PwC’s analysis of the NIP for new debt

contained an error in interpreting bond yield data and failed to take

into account actual data on NIPs provided by HAL as well as PwC’s

own information that NIPs were currently around 40bps to 50bps.

PARTIAL OMISSION OF REVOLVING CREDIT FACILITY

5.16 HAL noted that the CAA included only 5bps in the cost of debt for the

revolving credit facility, compared to HAL’s estimate of 17bps to

20bps. HAL considered that this left a short-fall of 12bps to 15bps,

even without the proposed move to a 24 month adequacy of


January 2014 21

resources licence condition.

ERRONEOUS CHANGE TO ‘MID-POINT’ OF Q6

5.17 HAL noted that PwC’s methodology for determining the forward

adjustment to the cost of new debt required it to assume a ‘mid-point’

of Q6 against which to measure the forward adjustment to interest

rates. HAL noted that for the initial proposals PwC took this mid-point

to be September 2016, which approximated to the mid-point of Q6

running from April 2014 to March 2019. For the final proposals,

however, PwC moved this ‘mid-point’ to June 2016. HAL calculated

that this change reduced the forward curve by 6bps, depressing the

WACC by 1bp.

OMISSION OF THE IMPACT OF NON-STERLING DEBT

5.18 HAL considered that the CAA took the theoretical position that if

sterling debt costs were lower than non-sterling (plus hedging costs),

then HAL would raise slightly more debt in sterling markets until the

costs equalised. HAL considered that this ignored the fact that

diversification across sterling and non-sterling markets not only sought

to minimise costs but also provide financial resilience. HAL

considered that borrowing in non-sterling markets, at the margin,

would be more expensive than borrowing in sterling markets, but was

nevertheless an optimal business decision. HAL estimated that taking

account of non-sterling debt hedging costs would add 3bps to the

WACC.

ARBITRARY OVERLAY TO COST OF DEBT RANGE

5.19 HAL considered that the CAA’s range for the cost of debt incorporated

a downward adjustment of 25bps to the top end of the range for the

cost of new debt. HAL considered that this overlay was intended

solely to allow variation between the cost of new debt for GAL relative

to that of HAL. This approach was not sustainable. In its view the

downward adjustment to HAL’s cost of debt was totally arbitrary and

without foundation. It thought that an equally plausible approach

would be to increase GAL’s overall cost of new debt.

UPDATE TO LATEST MARKET YIELDS

5.20 HAL considered that PwC continued to base its analysis of the cost of

new debt on a single cut-off date/point in time, now 27th June 2013.

In HAL's view using a single reference date lacked the reliability of


January 2014 22

looking at an average of rates but if PwC persisted in a less reliable

single cut-off point, it should at least reflect the latest numbers

available. HAL quoted PwC that 'yields have markedly increased

since March 2013' and that 'Gilt yields may, in time, increase to even

higher levels, but we suggest regulators follow this trend'. HAL

calculated that if rates were updated to 7 October 2013, or if an

average of rates over the last 3 months was taken, the cost of new

debt would be higher by around 7bps, adding 1bps to the WACC.

FLAWED ANALYSIS OF THE COST OF NEW DEBT

5.21 HAL noted that PwC did not explicitly take account of the risk-free rate

(RFR) in estimating the cost of new debt. HAL noted that in its

response to the initial proposals it showed that a better approach is to:

start with a robust estimate of the RFR; then

add a debt premium.

5.22 Using this approach, HAL estimated the cost of new debt would be

3.86%.

GAL

5.23 Oxera, on behalf of GAL noted that although the CAA's estimate of

GAL's cost of debt (3.2%) was the same as GAL's submissions, GAL

should have a higher cost of debt than HAL. The reasons were that

HAL's risk was lower than GAL's and this enabled it to achieve a

higher credit rating at the assumed gearing level than GAL.

Furthermore GAL already had sufficient debt in place for Q6 (the CAA

estimated that the cost of new debt was below the cost of GAL's

existing debt).

Airlines

5.24 BA's response stated that 'it is the CAA’s proposals with respect to the

cost of debt that are most troubling, as in this regard British Airways

believes that the CAA has made a number of technical errors.... We

also believe that the CAA, by choosing to use HAL’s actual debt

(which includes acquisition debt and subordinate debt) rather than a

benchmark index, has inadvertently made an error of principle by

departing from its previous policy statement not to allow HAL to pass

through costs related to the airport's change in ownership.'

5.25 Cambridge Economic Policy Associates (CEPA), on behalf of BA


January 2014 23

considered that the appropriate inflation forecast was in the range

3.0% to 3.4% and significantly above PwC's estimate of 2.8%. CEPA

also estimated that if PwC's recommended WACC was adjusted for

what it considered was the CAA's view of inflation (3.0% to 3.1%) then

in effect the CAA's point estimates for the HAL and GAL WACCs were

greater than the top of PwC's range.

5.26 BA was critical of the CAA's use of Bank of America Merrill Lynch

(BoAML) bond indices. BA considered that the BoAML indices were

skewed for this purpose because of the inclusion of financial

institutions. BA considered that more appropriate indices showed that

the actual yields over Q5 would have been lower.

5.27 BA estimated that the cost of existing debt was overstated by 110bps

(the CAA estimates that this equates to 46bps on the WACC). BA

considered that the sample of HAL's bonds used by PwC and the CAA

was not appropriate in the calculation of the cost of existing debt

because:

it included debt rated below A- (which was not consistent with a

60% gearing assumption in circumstances where HAL had issued

debt 67% gearing all with A- rating);

it included bonds which were the subject of basis point incentives

established in order to achieve the re-financing associated with the

change in control of HAL and/or in order to allow gearing well over

60% and/or to allow easier payment of dividends;

by wholly excluding non-sterling bonds, PwC increased the average

tenor and thus increased the debt costs.

5.28 BA estimated that the cost of new debt was overstated by 150bps.

The CAA estimates this equates to 27bps on the WACC. BA

considered that CAA's estimate of new debt was flawed because:

it appeared that PwC had made a mathematical error in its

averaging of traded bond yields for HAL and GAL, inflating its range

by 10bps;

the CAA had made serious errors in how it made use of evidence

from benchmark indices;

for HAL, the CAA should have only looked at the cost of A- rated

debt as this rating was consistent with gearing of 60%.


January 2014 24

5.29 BA was also critical of the CAA for the final proposal's apparent

departure from the notional debt approach. BA considered that it was

an error of principle to allow HAL's actual costs of debt and that this

also led it to make a further error of principle in departing from its

previous policy statement not to allow HAL to pass through costs

relating to the airport operator's change in ownership. BA considered

that the CAA should have used benchmark indices only.

5.30 The Heathrow Airline Community11

provided work carried out by

Jonathan Mirlees-Black from RARE Infrastructure which argued that

the cost of debt had been overstated in three ways:

it used actual HAL actual cost of debt and notional gearing level;

it had not used the a forward-looking inflation estimate with the

benchmark bond indices; and

it used an estimate of inflation for new debt which is too low

compared to current expected inflation.

5.31 Based on BA and CEPA's work, the ACC concluded that the increase

in the cost of debt to 3.2% in the final proposals compared to the initial

proposals was unjustified. Further, the ACC considered that there

was no justification for the CAA simply to 'aim up' to deal with any

uncertainties. This was inefficient and not in the interests of

passengers because it locks in a high cost of debt and therefore

higher prices.

CC's NIE Provisional Determination

5.32 The CC estimated the cost of debt for NIE by taking a blend of

historical fixed rate debt (80%) and new debt (20%). The CC

estimated that the real cost of existing debt was 3.6% and the real

cost of new debt was approximately 2.4%. The CC included an

additional allowance to cover issue fees (10bps) and for holding cash

ahead of use (20bps) and added these to new debt only. The

calculation of the cost of debt in the CC's NIE provisional

determination is summarised in the table below.

11

Virgin's response explicitly supported this work.


January 2014 25

Figure 5.3 CC's cost of debt for NIE

Nominal Real

Historical fixed rate debt (80%) 6.50% 3.60%

New debt (20%) 5.40% 2.40%

Issue fees and cash holding costs

(added to new debt only)

0.30% 0.30%

Cost of debt including fees 6.34% 3.40%

Source: CC's NIE Provisional Findings


Review of Q5

5.33 BA was critical of the CAA's use of BoAML bond indices. The CAA

notes that the purpose of the comparison of the Q5 cost of debt

assumption to actual yields during Q5 (using BoAML indices) was to

provide background to the Q6 review and to refute the claim that

airports had been under rewarded during Q5.

Approach to the notional debt

5.34 The CAA has previously stated that it sets the cost of capital for a

notional financed airport operator and does not take into account the

actual ownership or actual finance structure. BA considered that, by

taking into account yields on HAL and GAL's actual bonds the CAA

has departed from that policy.

5.35 The CAA continues to consider that the cost of capital should reflect

that of a notionally financed airport operator.12

The CAA also tries to

ground its analysis in market data and in particular data which

provides evidence as to how investors view the risks and therefore the

required returns for investing in HAL and GAL. The CAA notes that at

the time of the Q5 decision, there were only a few BAA traded bonds.

5.36 The CAA is aware that, by taking into account evidence on HAL and

GAL's actual bonds, the CAA might appear to have discarded the

12

Placing to one side the use of HAL and GAL's actual bonds as a source of evidence, the CAA's

final proposals' cost of debt estimate used the following notional assumptions: gearing;

proportion of new debt required in Q6 (based on RAB assumptions in the price control); cost of

new debt and floating rate debt; proportion of debt which is index-linked (for the purposes of

financeability testing); fees; credit rating; structure (e.g. senior and junior); and credit

enhancements (such as security over assets).


January 2014 26

notional debt approach, therefore giving stakeholders (including

investors) the expectation that the cost of actual debt is a 'pass

through' for Q6 and future control periods. This is not the case. The

CAA has used evidence on the cost of HAL and GAL's bonds because

it considers that the yields on these bonds are not out-of-line with

benchmark indices for the same ratings at the time of issuance and

therefore can be considered efficiently incurred. If there had been no

such alignment, the CAA would not have used the evidence.

Accordingly the CAA is not departing from the notionally financed

company nor is the actual cost of debt a pass through.

5.37 In the final proposals the CAA used a range of evidence in order to

inform its estimate of the cost of debt including benchmark bond

indices and did not solely use yields on HAL and GAL bonds.

Overall cost of debt

5.38 As set out above, HAL raised numerous points all of which it

considered showed that the CAA's final proposals understated the

cost of debt. Oxera considered that although the final proposals' cost

of debt allowance for GAL was the same Oxera had proposed, the

CAA should allow GAL a higher cost of debt than it allowed HAL. BA

and CEPA raised points all of which they considered showed that the

CAA's final proposals overstated the cost of debt.

5.39 The CAA has used the CC's approach to NIE's cost of debt to double

check the final proposals and see if any material differences exist.

The CAA has substituted its estimate of nominal historical cost of debt

for HAL and GAL into the CC's model, but left all other assumptions

made by the CC unchanged. The CAA calculates that using the CC's

methodology and assumptions the cost of debt:

for HAL would have been 3.26% (that is 6bps higher than the

CAA's final proposals); and

for GAL would have been 3.11% (that is 9bps lower than the CAA's

final proposals).


January 2014 27

Figure 5.4 Comparison of CC's NIE provisional determination and the

CAA's final proposals

CC NIE HAL GAL

Historical fixed rate debt (80%) 3.60% *3.40% *3.21%

New debt and floating rate debt (20%) 2.40% 2.40% 2.40%

Fees (added to new debt only) 0.30% 0.30% 0.30%

Cost of debt including fees 3.40% 3.26% 3.11%

Difference to CAA final proposals (3.2%) 0.20% 0.06% -0.09%

* The CAA has used its estimate of the nominal cost of historical fixed rate debt of 6.3% (HAL) and 6.1%

(GAL) and deducted inflation in the same manner as the CC. In the CAA's final proposals these figures,

after deducting inflation, were 3.3% and 3.1%.

Source: CAA analysis

5.40 The CAA considers that the CC's provisional determination does not

suggest the CAA should revise its final proposals for the cost of debt.

Inflation

5.41 Based on work by CEPA and RARE Infrastructure, airlines considered

that in the final proposals the CAA had been inconsistent with its

inflation assumptions, had applied them incorrectly and had

understated the inflation rate.

5.42 Inflation assumptions in the cost of debt calculation are required

because corporate debt yields are expressed in nominal terms (ie

include an allowance for inflation) and the CAA (and most other

regulators) set a real cost of capital (ie excluding an allowance for

inflation). When adjusting market data for inflation, two issues need to

be considered:

whether the adjustment is for expected inflation or actual inflation;

and

how the inflation assumption is estimated.

5.43 The price an investor is willing to pay for a bond (and therefore the

yield that they require) reflects the investor's expectations of the

future, including its expectations of future inflation (until the expected

redemption date) at the time it purchased the bond. 13

13

An alternative approach is to assume that the nominal cost of debt in the constant and

therefore the forecast inflation for the control period is the appropriate estimate (i.e. the


January 2014 28

5.44 Estimating investors' expectations of inflation is not straight-forward

and a number of possible sources of evidence exist.

Recent actual inflation (on the assumption that the recent past is a

good guide to the future). RPI inflation for the year to November

2013 was 2.6%.

Forecasts by independent forecasters and government. Forecasts

vary by forecaster and by year, and are in the range of 2.8% to

3.5% for the period up to 2018.

breakeven inflation (the implied inflation rate calculated by

comparing government index-linked bonds with government

conventional bonds). For example at 30 November 2013 the

implied inflation spot curve suggested inflation was 2.7 (derived

from gilts with 2.5 years to maturity) to 3.7% (from gilts with 25

years maturity)

5.45 Ideally the choice of inflation assumption needs to reflect the future

inflation expectations at the same point in time as the market data on

the bond and cover the period of time to that bond's maturity. On their

own none of the sources of inflation estimates provides this

information in the required detailed and reliable form. Therefore, in

the final proposals the CAA used a range of estimates, and attempted

to be as transparent as possible in these assumptions.

5.46 The CC's NIE work assumed inflation of 2.8% in respect of embedded

debt and the mid-point of the range 2.7% to 3.2% for new debt.

5.47 PwC's advice was based on an assumption of 2.8%. In the final

proposals the CAA also undertook some analysis using an inflation

rate of 3%.14

Ultimately the choice of inflation estimate is a matter of

judgement. While other inflation rates are also plausible, the CAA

considers that its assumptions as an estimate of the expected future

inflation rate contemporaneous with the market data are appropriate

and within the range of plausible estimates.

expected rate of inflation to be applied to the RAB). 14

CEPA considered that the CAA had made an error in not using the Fisher Equation in some of

its analysis. The CAA agrees that the Fisher Equation is theoretically preferred, but notes that

the simple deduction method used by the CAA in some of its analysis is within the margin of

accuracy of the underlying inflation estimate.


January 2014 29

Cost of existing debt

Non-sterling bonds

5.48 HAL considered that by omitting the cost of non-sterling bonds PwC

and the CAA had understated the cost of new debt. The CAA has not

omitted non-sterling bonds in the calculation of the cost of debt, but

instead concluded that the cost of sterling debt was an appropriate

proxy for the cost of non-sterling debt (including any associated

foreign exchange instruments).

5.49 HAL considered that the cost of non-sterling debt would be slightly

more than the cost of sterling debt.

5.50 BA and RARE Infrastructure (on behalf of the Heathrow Airline

Community) considered that non-sterling bonds may be cheaper than

sterling bonds because of the shorter tenor.

5.51 On the balance of the evidence the CAA continues to consider that

the cost of sterling bonds remain a good proxy for the cost of non-

sterling bonds.

Credit rating assumption

5.52 BA considered that for HAL the CAA should assume a rating of A- at

gearing of 60%. The CAA's assumption, consistent with Q5 is for a

solid investment grade (BBB/BBB+) at 60% gearing, which is slightly

lower than HAL's actual rating of A- at 68% gearing. The CAA

considers that while HAL might be able to achieve a higher rating than

the CAA has assumed, the CAA's gearing and credit assumption

gives it comfort that HAL will be able to finance its activities over Q6.

The CAA also notes that HAL's actual financing includes credit

enhancements including security over assets and cross guarantees.

Consistent with the policy to move to a full financial ring-fence over

time, the CAA has assumed a simple debt structure which does not

include such credit enhancements.

Use of HAL bonds

5.53 BA considered that the CAA had overestimated the cost of debt

because it included HAL's bonds which were the subject of basis point

incentives established in order to achieve the re-financing associated

with the change in control of HAL and/or in order to allow gearing well

over 60% and/or to allow easier payment of dividends. BA considered


January 2014 30

that the CAA should have used benchmark indices only. The CAA

notes that PwC compared HAL and GAL bonds to benchmark indices

and concluded that the airports' bonds were issued at yields to

maturity that were less than the benchmark indices.

5.54 BA considered that PwC had made a mathematical error in its

averaging of traded bond yields for HAL and GAL, inflating its range

by 10bps. The CAA also calculated weighted averages of the bond

yields which confirmed PwC's work.

5.55 In the round, the CAA considers that its estimate of the cost of existing

debt in the final proposals remains appropriate.

Cost of new debt

5.56 The CAA does not consider that PwC's forward-looking adjustment is

flawed. PwC clearly sets out the broader concept behind the

adjustment - that Quantitative Easing (QE) affected the yields on

government gilts the most and corporate bonds slightly less. PwC

noted that as QE unwinds the forward curve suggests that gilt yields

will rise by c90bps. PwC considers that the unwinding will affect

corporate bonds slightly less and PwC had estimated this to be

c70bps. Had the PwC not used any forward-looking adjustment the

pre-tax WACC would have been c12bps lower. If the CAA used

HAL's preferred 'one-to-one' relationship the CAA calculated that the

pre-tax WACC would have been 3bps higher.

5.57 HAL considered that the change in mid-point in PwC's estimate of the

forward-looking adjustment was inexplicable and meant that the

WACC was understated by 1bp. PwC's change in mid-point arose

because of the availability of data, is consistent with the reduction in

length of the control period by three months and the impact, as

calculated by HAL, is trivial.

5.58 HAL considered that the CAA’s range for the cost of debt incorporated

a downward adjustment of 25bps to the top end of the range for the

cost of new debt and that this was arbitrary. The CAA considers that

because of a lower risk profile HAL is clearly towards the bottom of

this range. In fact the CAA took the mid-point in the cost of new debt

range estimated by PwC (2.6%) and reduced it slightly for a higher

inflation forecast than assumed by PwC.

5.59 HAL considered that PwC's estimate of the cost of new debt was over


January 2014 31

reliant on a single data point and that PwC had acknowledged that

yields were increasing. HAL considered that this meant that the final

proposals understated the cost of debt. In contrasts, CEPA

considered that the reliance on a single cut-off date meant that the

final proposals overstated the cost of debt. The CAA notes that:

PwC combined spot rates with the forward-looking adjustment and

hence had allowed for an increase in yields going forward.

Movements in the market since PwC's cut-off date are consistent

with PwC's recommendations.

PwC tested its assumption on the cost of new debt to recent period

averages. Furthermore, in the final proposals, the CAA also set out

the 12 month average for A and BBB rated bonds of 1.1% and

1.8% respectively. These averages are less sensitive to the cut-off

date and once PwC's forward-looking adjustment (70bps) is

included, they suggest that the cost of new debt is in the region of

1.8% to 2.5%.

5.60 The CC's estimate of the cost of new debt for NIE (2.4%) was slightly

below the CAA's assumption in the final proposals for HAL (2.5%) and

significantly below the CAA's assumption for GAL (2.75%). The

CAA's cost of new debt for HAL was based on the mid-point of PwC's

recommended range, and its cost of new debt for GAL was higher to

reflect the lower credit rating achieved by GAL.15

5.61 In October 2013, HAL raised £750 million by issuing a 35 year bond at

a yield of 4.6% (rating A-). After deducting inflation this equates to a

real cost of debt in the region of 1.6 to 1.8%. The final proposals

assumed that the cost of new debt for HAL over Q6 would be 2.5%,

which was based on current rates of 1.8% plus PwC's forward-looking

adjustment (0.7%) to reflect the unwinding of QE over Q6.

5.62 HAL's debt issuance in October is consistent with and therefore

supports the CAA's final proposals.

15

With actual gearing of 62% GAL achieved a credit rating of BBB+, while with actual gearing of

67% HAL achieved a credit rating of A- (and with an actual gearing level of 78% HAL achieved

a rating of BBB).


January 2014 32

Fees and new issue premium

5.63 One difference between the CC's NIE provisional determination and

the CAA is the allowances for fees - the CC allowed for significantly

lower fees that the CAA. The CC included an allowance for issue

costs of 10bps on the cost of new debt. In addition, unlike the CAA,

the CC allowed holding costs (ie the cost of drawing down funds and

holding them before they are needed) on new debt of 20bps.

Combining these figures, they equate to 6bps on the overall cost of

debt. In comparison the CAA allowance for fees was 15bps for HAL

and 20bps for GAL. Consistent with its previous price controls, the

CAA did not include an allowance for holding costs.

5.64 HAL reiterated its previously expressed views and stated that the CAA

should include a NIP on the new debt. The CAA notes that its

approach to estimating the cost of existing fixed rate debt means that

if the NIP exists it is already included in the cost of existing debt. The

CAA notes HAL's views that the cost of new debt should include an

additional, specific allowance for NIP. Given the CC did not provide

for a specific additional allowance to cover any NIP, the CAA

continues to consider that consistent with PwC's advice, it is not

appropriate to include an additional allowance for Q6.

5.65 HAL considered that the CAA had not fully allowed for the costs of its

revolving credit facility. The CAA notes that the fees allowance for

HAL included in the final proposals is the same as that allowed in Q5

and greater than that allowed by the CC in its NIE provisional

determination. Furthermore, as previously noted, other regulators

such as Ofgem, provide no allowance for such fees. The CAA

considers that on balance the allowance for fees included in the final

proposals remains appropriate.

5.66 RARE Infrastructure noted that short maturity debt is significantly

cheaper than longer maturity debt. This means that to fund short-term

liquidity the airports can borrow short-term (at rates less than the

CAA's cost of debt assumption on new debt) rather than issue long-

term debt and suffer the cost of carry. The CAA considers that the

treasury policy is a matter for the companies and is not advocating

any specific treasury approach, but highlights this issue to show that

there are alternative approaches. Furthermore this demonstrates that

the cost of debt should be viewed in-the-round rather than giving

focus on individual components in isolation.


January 2014 33

Final view on the cost of debt

5.67 HAL considered that the CAA should update its estimates for the

latest market evidence and calculated that this would increase the

WACC by 1bp.

5.68 The CAA has not updated its cost of debt assumption for the latest

market evidence. By taking an approach which places limited reliance

on the choice of data cut-off, the CAA considers that its cost of debt

assumption is robust to the usual market movements. Furthermore,

purpose of the uplift applied to the cost of new debt is to reflect PwC's

view that debt yields will slowly rise over Q6. Furthermore the effect,

as calculated by HAL, is trivial.

5.69 The CAA has considered the issues raised in responses to the final

proposals in-the-round. The CAA considers that the range identified

by PwC remains the appropriate range. The appropriate point

estimate is a matter of judgement and therefore it is not surprising that

some responses to the consultation present argument and evidence

to suggest that the cost of debt allowance is too high, while some

responses suggest that it is too low.

5.70 Taking all the evidence in-the-round the CAA considers that the cost

of debt of 3.2% in the final proposals remains appropriate for Q6.

Furthermore, the CAA's estimate is consistent with the CC's NIE

provisional determination and the debt issued by HAL since the final

proposals.

CAP 1140 Chapter 6: Estimating the WACC: cost of equity

January 2014 34

CHAPTER 6

Estimating the WACC: cost of equity

Total market returns, risk-free rate and the equity risk

premium

Final proposals

6.1 In the final proposals the CAA used a TMR assumption of 6.75%, a

RFR assumption of 1.0% and therefore an ERP assumption of 5.75%.

The CAA also noted that these were current rates but that the PwC's

current TMR was not significantly different to longer-run rates.

6.2 The analysis included in the final proposals showed that, while there

was significant debate around the RFR, all submissions were

consistent with TMR in the range 6.25 to 7.25%. The final proposals

noted that focusing on the TMR and taking a longer run view of equity

returns provided stability in this key element of the CAPM.

6.3 The analysis in the final proposals showed that if the CAA were to

have used HAL's preferred TMR, RFR and ERP assumptions (rather

than the CAA's proposals) the pre-tax WACC would be higher by only

9bps. A similar analysis using BA's preferred assumptions would

have led to a pre-tax WACC that was only 4 to 5bps lower than CAA.

If the CAA had used the Q5 assumptions, then the WACC would have

been only 6bps higher than the CAA final proposals. The CAA

considered that all these differences were within the margin of

accuracy of estimating the cost of equity.

6.4 Only GAL's estimate which used the highest TMR of 7.25% would

have led to a materially different WACC (c25bps) than the CAA's

assumptions. The CAA noted that GAL's assumption was consistent

with Ofgem’s 2012 determination16

, but it would not have been correct

to say that there is regulatory consensus on this issue - for example

ORR's June 2013 draft determination used a range of 6.25 to 6.75%17

and Ofcom was using a TMR assumption of 6.3% (comprising RFR of

16

Since the publication of the final proposals, Ofgem has used a TMR of 6.85% in its

assessments of business plans. 17

These figures were confirmed in its Final Determination.


January 2014 35

1.3% and ERP of 5%). The CAA noted that PwC examined a range of

evidence including its own dividend growth model estimates, which

supported a TMR assumption of less than 7.25%.

Responses

HAL

6.5 HAL considered its estimate of TMR of 7% remained appropriate and

that:

PwC appeared to misinterpret the evidence on regulatory

precedent, which led to the unjustified conclusion that there was a

downward TMR trend relative to Q5;

the single period dividend growth model (DGM) PwC used to

estimate the forward-looking TMR was too simplistic, resulting in a

potentially inaccurate estimate of true forward-looking TMR; and

PwC ignored current market evidence based on more sophisticated

DGM models provided by the Bank of England and Bloomberg

which supported a figure of at least 7% for the forward-looking TMR

and thus also could not support a downward trend relative to when

the CAA last set prices.

GAL

6.6 Oxera on behalf of GAL noted that the assumed TMR was broadly

appropriate, given capital market uncertainty. Oxera noted:

The CAA’s upward revision of the TMR was supported by the

volatility observed in capital markets since the CAA’s initial

proposals, as well as by the regulatory determination by the ORR.

However, the CAA omitted any reference to Ofgem’s March 2013

strategy decision for Electricity Distribution, which proposed an

upper bound of 7.5% for the TMR range (mid-point of 7.0%).

Heightened uncertainty in capital markets persists, following the US

Federal Reserve’s announcement to withdraw QE and the ongoing

US government budget crisis, combined with uncertainty regarding

economic growth.


January 2014 36

Furthermore, UK government yields had risen since April 2013, as

recognised by the CAA. In light of this, a 6.75% estimate of the

TMR appeared reasonable, although higher estimates would also

be consistent with ongoing capital market uncertainty and

regulatory precedent.

Airlines

6.7 Although BA did not raise any specific points on the TMR, other than

to support the CC's estimate, which it calculated was 100bps18

below

the CAA's estimate, it considered that there was no rationale for

choosing a point estimate above the mid-point of the WACC. CEPA,

for BA, suggested that the CC's provisional determination justified

further scrutiny of the CAA's assessment.


provided work from RARE

Infrastructure which argued that the cost of equity had been

overstated because the CAA used an ERP of 5.75%, which was

higher than other UK regulators and above a level typically used in

financial markets.

CC's provisional finding on NIE

Figure 6.1 TMR extract from the CC's Provisional Determination on NIE

13.144 The interpretation of the evidence on market returns remains subject to considerable uncertainty.

The CC has said in recent regulatory inquiries that 7 per cent is an upper limit for the expected market

return, based on the approximate historical average realized return for short holding periods. We think

that it may be appropriate to move away from this upper limit based on historical realized returns and

place greater reliance on forward-looking estimates which tend to support an upper limit of 6.5 per cent.

We note the following points in support of setting an upper limit for the market return of 6.5 per cent:

(a) We consider that the return on the market is a more stable parameter than the ERP. However, it

remains the case that it exhibits considerable volatility and cannot therefore be regarded as fixed over

time.

(b) We consider that there is logic to the proposition that a long-term decline in RFRs, as we discuss

above, should correspond with an increased demand for equities and thus increased prices and lower

returns.

(c) We note research conducted by DMS suggesting a clear relationship between real interest rates

and real returns on equities and bonds in the subsequent five-year period.45

(d) A forward-looking expectation of a return on the market of 7 per cent does not appear credible to

18

The CAA estimates the difference is in the region of 75bps to 85bps. 19



January 2014 37

us, given economic conditions observed since the credit crunch and lowered expectations of returns.

13.145 Further, the implied range for the ERP of 4 to 5 per cent46

appears consistent with the following

evidence:

(a) the lower end of the 5 to 6 per cent range suggested by the pure historical analysis conducted by

DMS (see paragraph 13.133);

(b) DMS’s decomposition approach (see paragraph 13.136) suggesting an ERP of 4.5 to 5 per cent;

and

(c) Fama & French’s forward-looking projections based on the DGM suggesting an ERP of 4.4 per

cent (see paragraph 13.134).

13.146 Based on the above, we consider that the appropriate upper limit for the market return is 6.5 per

cent. In the context of setting a cost of capital for NIE, we are less concerned with a lower limit to the

expected market return (since we would wish to avoid NIE’s cost of capital being too low), but in this

context we consider 5 per cent an appropriate lower bound figure.47

13.147 We therefore provisionally estimate a range of 5 to 6.5 per cent for the market return, and implied

range of 4 to 5 per cent for the ERP.

Footnotes

45 Credit Suisse Global Investment Returns Yearbook 2013, Figure 5.

46 We associate the lower market return (5 per cent) with the lower RFR (1 per cent) and the higher

market return (6.5 per cent) with the higher RFR (1.5 per cent).

47 Figures lower than 5 per cent may well be appropriate in other contexts, for example providing advice

to equity investors on the lower end of the range of expected returns before costs. In this context, we

note that the Financial Services Authority (FSA) requires UK financial advisers to project nominal returns

on a notional product two-thirds invested in equities and one-third in fixed income (before costs and

personal tax) using rates of 5, 7 and 9 per cent. From 2014 onwards the FSA has reduced the assumed

returns to 2, 5 and 7 per cent. Assuming RPI of 2.9 per cent, this implies real returns of –0.9, 2.1 and 4.1

per cent.

Source: http://www.competition-commission.org.uk/assets/competitioncommission/docs/2013/northern-

ireland-electricity-price-determination/131112_main_report.pdf.


Total market returns

6.9 Contrary to HAL's response, PwC used both a single period DGM and

a two period DGM.

6.10 HAL considered the Bank of England analysis suggested a TMR of

7%, however, the CAA notes that the CC's analysis of the Bank of

England data suggests the TMR fluctuates around 6.5%.

6.11 The CC and the CAA took a similar approach to considering the TMR

http://www.competition-commission.org.uk/assets/competitioncommission/docs/2013/northern-ireland-electricity-price-determination/131112_main_report.pdf

http://www.competition-commission.org.uk/assets/competitioncommission/docs/2013/northern-ireland-electricity-price-determination/131112_main_report.pdf


January 2014 38

and ERP. First, that the TMR is a key component in the estimation of

the ERP and second, that both historical evidence and forward-

looking evidence should be considered.

6.12 Compared to the final proposals and PwC's advice to the CAA, the

CC's provisional determination on NIE appears to present two broad

differences:

additional evidence on the estimate of the TMR; and

a different weight placed on historical estimates compared to

forward-looking estimates.

6.13 The additional evidence included in the CC's report all points to a

lower estimate of the TMR than the CAA assumed in its final

proposals (6.75%).

Fama and French approach to estimating historical TMR suggested

the long-run TMR was in the region of 5.5% and possibly around

4.5% more recently.

A forward-looking estimate which, although similar in approach to

PwC, assumed that dividend growth would be lower than Gross

Domestic Product (GDP) growth. (PwC assumed that long-run

dividend growth would be the same as GDP growth). The CC's

method suggested 6.5% was the upper limit of the TMR.

6.14 The CC appeared to place greater emphasis on forward-looking rates

and is clearly concerned only with the return required for that period.

In NIE's case this is the period 1 April 2012 to 30 September 2017. In

contrast, the CAA's final proposals placed greater emphasis on longer

run averages, and used a point estimate of 6.75% (the top of PwC's

recommended range of 6.25% to 6.75%).

6.15 The CAA notes that its RAB-based control period runs from 1 April

2014 to 31 March 2019 (or 31 December 2018 for HAL), while the

CC's review covers the period 1 April 2012 to 30 September 2017.

Therefore while there is a large degree of overlap, the two periods are

not identical.

6.16 The CAA also notes that forward-looking estimates require more

judgements to be made and are inherently more unstable - for

example the reliance on forward-looking assumption of dividend

yields.


January 2014 39

6.17 The CC's provisional determination was unambiguous: 6.5% was the

upper limit. Therefore the CAA's view set out in the final proposals

that the appropriate TMR was 6.75% is not consistent with the CC. In

the final proposals, the CAA noted that PwC recommended a range

for the TMR of 6.25% to 6.75%. The CAA also noted that the range

was probably 6.5% to 7%, the upper end reflected some of the higher

historical evidence and regulatory decisions in other sectors. The

CC's NIE work suggests that the appropriate range is 5.0% to 6.5%,

although the CC also suggests that there is less support for the lower

end of its range. In light of the CC's provisional determination, the

CAA considers that it is appropriate to place more weight than it did in

its final proposals on the forward-looking estimates and take into

account the new evidence which suggest the historical estimates

might be lower than the CAA had previously considered. However,

the CC's point estimate of approximately 5.9/6.0% appears below all

other evidence that the CAA has received and below PwC's

recommended lower estimate of 6.25%.

6.18 The CAA is also aware that in 2010 the Office of National Statistics

(ONS) changed the way in which RPI inflation was calculated, which

led an increase in measured RPI inflation of approximately

50bps20

(the formula effect). This means that any estimate of the real

(RPI-stripped) TMR before 2010 is likely to be c50bps higher than

estimates after 2010. PwC estimated the difference to be 32bps.

Ofgem recognised this in its recent assessment of Electricity

Distribution business plans when it estimated that the formula effect

was 40bps and reduced its TMR from 7.25% to 6.85%.

6.19 The CAA therefore concludes that the low end of the plausible range

for the TMR in the final proposals was too high and that there is

evidence, as put forward by the CC and the impact of the RPI formula

effect, to suggest that the TMR could be as low as 5.5% or 6%.

6.20 In light of the additional evidence arising from the CC's NIE provisional

determination the CAA has revised its point estimate for the TMR to

6.25% which is 50bps lower than its final proposals.

6.21 The CC's views on TMR (and all components of the WACC) are

20

http://www.ons.gov.uk/ons/about-ons/get-involved/consultations/archived-

consultations/2012/national-statistician-s-consultation-on-options-for-improving-the-retail-

prices-index/options-for-improving-rpi-consultation-document.pdf.

http://www.ons.gov.uk/ons/about-ons/get-involved/consultations/archived-consultations/2012/national-statistician-s-consultation-on-options-for-improving-the-retail-prices-index/options-for-improving-rpi-consultation-document.pdf




January 2014 40

provisional, and the final determination is expected in 2014. It is

possible that the CC revises its views for the final determination and

uses a TMR which is greater or less than the 6%. In reaching its final

views the CAA is cognisant the CC final determination may differ to its

provisional determination. The CAA has linked its revision in the TMR

to the new evidence presented by the CC rather than specifically to

the CC's choice of a point estimate for the TMR of 6%.

6.22 The CAA considers that its view that the appropriate TMR assumption

of 6.25% is consistent with the CC's estimate of 6% because of the

slightly different time periods covered by price controls. There may be

some reversion to the longer run historical rates towards the end of

Q6 (and after the end of the NIE control period on which the CC has

opined). The CAA also notes that this is consistent with Q5 when the

ARR and the ONS change to inflation are taken into account.

Risk-free rate and the equity risk premium

6.23 Once a view on the TMR is reached, the purpose of the RFR is to split

the TMR into the RFR and the ERP. The final proposals included a

RFR of 1%. PwC's recommended range for the RFR was 0.5% to

1%. In effect, the choice of RFR makes little difference to the cost of

equity once the TMR is fixed.

6.24 Having decided to reduce the TMR compared to the final proposals,

the CAA has assessed options - reduce the RFR, reduce the ERP or

a mixture of the two.

6.25 PwC's advice was that the appropriate ERP was 5.75%, and that the

range for the RFR was 0.5% to 1.0%.21

In order to remain consistent

with PwC's advice the CAA's view is that the ERP should be 5.75%

(unchanged from the final proposals) and the RFR should be 0.5%

(reduced from 1.0% in the final proposals). For the avoidance of

doubt, the reduction in the RFR is to ensure consistency and is a

consequence of the reduction in the TMR, and should not be viewed

in isolation from the TMR and ERP. Furthermore, the CAA's approach

to estimate the total cost of debt (rather than the RFR and the debt

premium separately) means that the RFR estimate does not affect the

cost of debt.

21

PwC's advice was that the RFR was in the range 0.5% to 1.0% and was consistent with the

TMR range of 6.25% to 6.75%.


January 2014 41

6.26 The CC estimated that the appropriate range for the RFR was 1.0 to

1.5% and the ERP was 4 to 5%. The CC narrowed this range slightly

by increasing the lower end of the range by 50bps. In effect the CC

used a RFR of approximately 1.25% and an ERP of approximately

4.75%.

6.27 If the CAA used the CC's RFR estimate (1.25%) and the CAA's TMR

and equity beta estimate of HAL22

(6.25% and 1.10 respectively) the

post-tax cost of equity would be 6.77%. Alternatively, if the CAA used

the CC's ERP estimate (4.75%) and the CAA's TMR and equity beta

estimate for HAL, the post-tax cost of equity would be 6.74%. The

proximity of these estimates (6.77% and 6.74%) and CAA's estimate

of the post-tax cost of equity for HAL of 6.84% leads the CAA to

conclude that, consistent with its view in the final proposals, once the

TMR is set, the cost of equity is not significantly affected by the choice

of RFR (within a reasonable range).

Beta and equity risk

Final proposals

6.28 The CAA considered demand risk (also called traffic risk or volume

risk) is a systematic risk and that airport operators are exposed to

demand risk in a way that water and energy are not. All other risks

being equal, the CAA considers that airport operator betas should be

higher than those of revenue capped regulated companies, which face

little or no volume risk. The CAA also considered that HAL and GAL's

resilient performance in economic downturn during Q5 demonstrated

the limited effect of downside risks.

6.29 The final proposals also noted that there was no double-counting of

risk in the cost of capital and the shocked traffic forecasts.

6.30 The final proposals included asset betas of 0.50 for HAL and 0.56 for

GAL, which at gearing of 60% and 55% equated to equity betas of

1.10 and 1.13 respectively.23

This was based on a range of evidence,

which examined both the level and the movement of betas, including:

the average beta estimate of listed airports and airport groups; and

22

The same conclusion is reached if GAL's beta is used. 23

A debt beta of 0.1 was also assumed and consistent with Q5 and the CC's NIE Provisional

Determination.


January 2014 42

the AdP and Fraport betas as an indicator of Charles de Gaulle and

Frankfurt airports respectively and therefore as an indicator of HAL

and, to a lesser extent, GAL.

6.31 The CAA reviewed other sectoral regulators' publications. The CAA

calculated from the National Grid Electricity Transmission (NGET)

price control that Ofgem used an asset beta of 0.44,24

and ORR's draft

determination for Network Rail (assuming no government support)

used an asset beta of c0.4325

. The CAA's asset beta for HAL (0.50)

was 14% higher than NGET and Network Rail and its asset beta for

GAL (0.56) was 27% higher than NGET and Network Rail.

6.32 The final proposals noted that other evidence on market-to-asset

ratios, actual gearing levels, credit rating reports and the CAA's

assessment of BA's five investor tests were consistent with its

conclusion on the risk of HAL and GAL.

6.33 The CAA's initial and final proposals used a tax rate of 20.2% tax for

Q6. This represented a simple average of the rates signalled by the

Chancellor (21% for 2014/15 followed by 20% in subsequent years).

The CAA rejected Oxera's suggestion (on behalf of GAL) that a higher

rate should be used to reflect the concept that actual tax is paid on

nominal not real equity returns. The CAA considered that 20.2% was

consistent with its previous approach and it was not clear, because of

trading losses, whether GAL would be paying Corporation Tax in the

near future.

6.34 Applying the tax rate (20.2%) to the CAA's post-tax cost of equity, the

point estimates for the pre-tax cost of equity were 9.2% for HAL and

9.31% for GAL.

Responses

HAL

6.35 HAL considered that the CAA had understated the equity beta and the

correct beta was 1.35 (final proposals: 1.10) and therefore the cost of

equity should be 51bps higher. HAL considered that:

24

To ensure consistency with the CAA proposals, a debt beta of 0.1 was used by the CAA in this

calculation. 25

To ensure consistency with the CAA proposals, a debt beta of 0.1 was used by the CAA in this

calculation.


January 2014 43

the CAA had failed to take into account HAL's risk relative to other

UK utilities;

PwC and the CAA's comparisons to other European hubs such as

AdP and Frankfurt was misleading;

the CAA had not fully explained its judgement on the appropriate

debt assumption and beta of comparator airports; and

pension risk had a strong systematic element and the CAA had not

taken sufficient account of the risks.

6.36 HAL also considered that the CAA should take into account the tax

plans of the Her Majesty's Official Opposition Party in setting the

appropriate tax rate for Q6.

GAL

6.37 Oxera, on behalf of GAL considered that the proposed asset beta for

GAL did not reflect the significant increase in Gatwick's risk. Oxera

thought that:

the CAA had not sufficiently considered the impact of competition

on risk;

the CAA had not sufficiently taken into account its analysis which

showed that Q6 systematic risk was 15% to 25% greater than Q5;

and that the increase in risk has been greater for GAL than either

HAL or Stansted Airport Limited.

6.38 Oxera also reiterated its previous point that the tax rate should be

applied to the nominal cost of equity not the real cost of equity and

that this increased the WACC.

Airlines

6.39 BA reiterated its view that it considered that HAL's equity beta was

less than one (the final proposals assumed 1.10) and that it had seen

no evidence to change its view.


provided work from RARE

Infrastructure which argued that the cost of equity had been

overstated because the CAA had increased its estimate of the asset

beta since the initial proposals. RARE Infrastructure considered that

26



January 2014 44

airport infrastructure and regulated assets with index-linked revenues

and regulatory asset values were attractive assets to a broad range of

investors.

6.41 In respect of GAL, the ACC considered that neither the CAA nor PwC

had taken account of the evidence provided that traffic risks in Q5

were not representative of future risks, because of the one-off effects

of the abolition of the Bermuda II agreement.


6.42 The CAA has seen no evidence or argument to change its views on

the appropriate beta contained in the final proposals. The CAA

remains of the view that there has been no material change in risk of

HAL and GAL relative to the economy and thus there is no change in

the asset beta.

6.43 In the final proposals the CAA set out a comparison of its beta

assumptions for HAL and GAL with National Grid and Network Rail,

and compared its vanilla WACC with those set by other regulators.

6.44 The CAA set out various beta estimates for comparative airports.

HAL compared volatility of traffic at HAL with Fraport group of airports

and AdP group of airports, and found it impossible to see how the

CAA could conclude that HAL had a lower asset beta than Fraport

and AdP. The CAA notes that its final proposals set out the reasons

why it was appropriate to conclude that HAL was lower risk than

Fraport and AdP - HAL had strong demand and was operating closer

to capacity.

6.45 In respect of pensions risk, the final view allows the recovery of

pension deficit costs in the operating expenditure (opex) allowance.

6.46 HAL considered that the CAA had not been clear as to the appropriate

measurement of debt in the gearing assumption used to re-gear betas

from comparator airport groups. The WACC annex to the final

proposals (paragraph 7.64 et seq) clearly noted the options and

expressed the CAA's view on this issue.

6.47 Oxera considered that increasing competition had increased the risk

of GAL. The CAA has recently undertaken a market power

determination and has concluded that GAL has substantial market

power and is likely to maintain substantial market power. The CAA

considers that it would therefore be inappropriate and inconsistent


January 2014 45

with its market power determination to conclude that the beta should

be increased because of competition.

6.48 GAL also noted that its analysis showed that GAL was riskier than Q5,

because its increase in absolute volatility had been greater than the

increase in absolute volatility at HAL and STAL. Unfortunately, Oxera

did not provide an analysis about how GAL's volatility compares to the

economy more widely. The CAA remains unconvinced that Oxera's

analysis shows that GAL is more risky compared to the market. The

airlines provided evidence showing that some of this absolute volatility

was due to one-off events.

6.49 BA and CEPA consider that the evidence previously submitted

suggested that HAL's equity beta was less than 1. The CAA

considers that it is slightly above 1 and its final proposals set out the

range of evidence on betas which supported this view.

6.50 The CAA notes that it and the CC's Q5 recommendations applied the

statutory tax rate to the real cost of equity. The CAA considers that it

is not appropriate to take account of the opposition party's tax plans.

6.51 On taxation, the CAA considers that a consistent approach is

preferred and therefore considers that the statutory tax rate, with no

adjustment other than to take into account the policy set out by the

government (as far as is known) is appropriate.

Final views

6.52 The CAA has considered the issues raise in responses to the final

proposals in the round. The CAA considers that the range identified

by PwC remains the appropriate range. The appropriate point

estimate is a matter of judgement and therefore it is not surprising that

some responses to the consultation present argument and evidence

to suggest that the cost of equity allowance is too high, while some

responses suggest that it is too low.

6.53 The CAA's final views are that the appropriate asset beta for HAL is

0.50 and for GAL is 0.56, and these translate into equity betas of 1.10

and 1.13 at 60% and 55% gearing respectively.

6.54 The appropriate tax uplift is 20.2% and that this is applied to the real

cost of equity.

6.55 Combining various assumptions, the CAA concludes that the


January 2014 46

appropriate pre-tax cost of equity is 8.58% for HAL and 8.76% for

GAL.

CAP 1140 Chapter 7: Estimating the WACC: conclusions

January 2014 47

CHAPTER 7

Estimating the WACC: conclusions

Point in the range

Final proposals

7.1 The CAA considered that the appropriate point estimate for the WACC

from the overall range was ultimately a matter of judgement. The

CAA set out the multi-step process that it followed. The CAA also

noted that the concepts that guide that judgement are often qualitative

in nature.

Whether the best estimate was the mid-point or that there was a

reason why it might differ to the mid-point.

Asymmetry of cost of getting the estimate 'wrong'.

The concept that returns earned during the year can be reinvested

in order that the WACC is earned for the year. (In effect, a lower

return can be given that the WACC in order for the airport operator

to earn the required return).

The consistency of the CAA's WACC proposals with the credit

rating metrics as set out in the final proposals document.

The greater flexibility that the licence-based regime introduces.

7.2 Considering these concepts, the CAA final proposals concluded that

the appropriate point estimates for the cost of capital were:

5.6% for HAL. This was 29bps (Q5: 38bps) from the top of the

range and represented the 79th percentile (Q5: 77th); and

5.95% for GAL. This was 36bps (Q5: 47bps) from the top of the

range and represented the 76th percentile (Q5: 75th).

7.3 The CAA considered that the WACC differential between HAL and

GAL (35bps) was appropriate because it reflected a better

understanding of the relative risks of the two airport operators now

that they are under separate ownership. Evidence included market

data on:


January 2014 48

the MARs27

(GAL MARs were noticeably lower than HAL);

a significantly lower level of actual gearing at GAL than HAL; and

the credit rating assessment of business risks and therefore the

credit rating differential of the actual finance.

7.4 The final proposals included a comparison to Q5 and noted that the

reduction was explained by lower tax rates (c40bps) and lower cost of

debt (20bps) and for GAL this was slightly offset by the effect of lower

gearing (8bps).

7.5 To facilitate comparison to other sectors the final proposals translated

the pre-tax WACC into vanilla WACCs of 4.85% (HAL) and 5.10%

(GAL). The CAA also had to make slight adjustments to some of the

other regulator's WACC to bring them onto a comparable basis. On

this basis, the final proposals noted that the differences in the WACCs

were consistent with the CAA's understanding of the differences in the

risks between the regulated industries. For example HAL's vanilla

WACC was 40bps greater than NGET and GAL was 88bps greater

than NGET.

Stakeholder views

HAL

7.6 HAL focused its comments on the components of the WACC

calculation. NERA on behalf of HAL noted that selecting the mid-point

ignored the asymmetric effects of getting the WACC estimate wrong

and ignores the asymmetric beta risks.

GAL

7.7 GAL focused its comments on the components of the WACC

calculation.

7.8 Oxera, on behalf of GAL noted that the CAA used a point estimate for

the total equity market return (6.75%) that was broadly consistent with

the CC’s Q5 final determination for GAL, where the point estimate was

at the 85th percentile, and the CC’s final determination for Bristol

Water, where the point estimate was at the top of the range. Oxera

noted that in these determinations, the CC justified point estimates

above the mid-point by a combination of capital market volatility and

27

Market-to-asset ratios. These show the ratio of market value to the value of the RAB.


January 2014 49

the costs of under investment in airports—both factors that Oxera

thought still apply to GAL today. Oxera also noted that in the

provisional determination for NIE, the CC had not explained why it had

departed from its own precedent of selecting a point estimate at or

near the top of the range. Oxera noted that it may be because NIE

was considered a low risk utility compared with a higher risk airport,

as Oxera considered was suggested by the following quotation from

the CC report: 'Our cost of equity for NIE is towards the lower end of

the range of the CC’s recommended cost of equity for the airports,

reflecting the lower risk that utility companies face compared with

airports.'28

Given the higher risk of airports relative to traditional

utilities, Oxera saw no reason for the CAA to depart from the

precedent of choosing a WACC point estimate towards the top end of

the CAA’s range.

Airlines

7.9 BA was critical of the CAA's choice of point estimate from the range.

BA consider that the CAA had:

not given proper consideration to the evidence placed before it;

not presented rationale backed by evidence for its point estimate;

and

inadvertently and erroneously chosen a point outside of PwC's

range (because of the different inflation assumptions).


provided work carried out by

RARE Infrastructure which argued that the CAA had not taken time to

examine what the developments in capital markets meant for what an

appropriate return was for an asset like HAL. The impact of lower

bond yields and other capital market developments was having a far

larger impact on decisions by Ofgem and Ofwat without any

detrimental impact on the supply of capital.

7.11 Virgin also noted the announcements30

by both HAL and Ferrovial,

28

Competition Commission (2013), ‘Northern Ireland Electricity Limited Price Determination—

provisional determination’, 8 November, para. 13.179 29

Virgin's response explicitly supported this work. 30

http://www.telegraph.co.uk/finance/newsbysector/transport/10397806/Ferrovial-sells-

Heathrow-stake-to-UK-pension-fund-for-392m.html

http://www.telegraph.co.uk/finance/newsbysector/transport/10410323/Heathrow-boosts-profits-

http://www.telegraph.co.uk/finance/newsbysector/transport/10397806/Ferrovial-sells-Heathrow-stake-to-UK-pension-fund-for-392m.html

http://www.telegraph.co.uk/finance/newsbysector/transport/10397806/Ferrovial-sells-Heathrow-stake-to-UK-pension-fund-for-392m.html

http://www.telegraph.co.uk/finance/newsbysector/transport/10410323/Heathrow-boosts-profits-at-Ferrovial.html


January 2014 50

which it considered provided clear empirical evidence that equity

investors see value in HAL at the return set in the initial price

proposal, let alone the more benign final proposal, and will continue to

invest through Q6.

7.12 The ACC did not support the CAA’s proposal to select a point 76%

along the range for GAL. The ACC considered that selecting a point

high in a range compounds uncertainties and possible errors within

each constituent range and also illogically assumes that many of the

numbers could be wrong in the same direction at the same time,

without considering whether some of these would be likely to balance.

7.13 The ACC also considered that the CAA was inconsistent with

approaches taken by other regulators and ignored the CAA’s stated

intention to make no reduction for the reinvestment of returns by GAL,

but to take this into account when selecting the point in the range.

ACC noted that the CAA asserted that the cost of underestimating

WACC was very much greater than the costs to passengers of over

estimating WACC and implied that the best estimate might be above

the mid-points of constituent range, but no further detail is given to

explain this.

7.14 The ACC disagreed strongly with the CAA statement that the decision

on the WACC is 'ultimately a matter of judgement' and considered that

the CAA had not justified its proposal, which appeared arbitrary.

7.15 The ACC considered that the CAA's Q6 approach was also

inconsistent with the specific circumstances of the Q5 review where

the future growth in the size of the RAB was larger (33% growth over

Q5 compared to 3% for Q6): investment in Q5 was clearly more

important and strategic and the consequences of getting it wrong were

now much less significant. In Q5, the CAA had already made what

was then a relatively large change in WACC.

CC's NIE Provisional Determination

7.16 The CC's NIE provisional determination concluded that the possible

range for the vanilla WACC was 3.6% to 4.5%. The CC concluded

that the value was unlikely to lie at the very top or the very bottom of

at-Ferrovial.html

http://mediacentre.heathrowairport.com/Press-releases/Heathrow-SP-Limited-Results-for-the-

nine-months-ended-30-September-2013-6ce.aspx

http://mediacentre.heathrowairport.com/Press-releases/Heathrow-SP-Limited-Results-for-the-nine-months-ended-30-September-2013-6ce.aspx

http://mediacentre.heathrowairport.com/Press-releases/Heathrow-SP-Limited-Results-for-the-nine-months-ended-30-September-2013-6ce.aspx


January 2014 51

this range. Furthermore the CC considered that the lower bound for

its TMR was less well supported by evidence as the upper end of its

TMR. The CC narrowed its range to a give a plausible range for the

vanilla WACC was 3.9 to 4.3%. The CC then chose the mid-point of

the plausible range as its point estimate for the vanilla WACC (4.1%).

When the point estimate is compared to the initial range (3.6% to

4.5%) the CC's point estimate reflects the 55th percentile.

7.17 The CC's approach of taking the mid-point of the plausible range for

NIE is in contrast to previous CC reports on HAL, GAL, StAL and

Bristol Water which used point estimates in the top quartile including

the very top of the range.


Summary of range

7.18 The estimate of the cost of capital is ultimately a matter of judgement.

Some responses described differences in judgements between the

consultee and the CAA to be errors. The CAA has considered a

range of evidence and therefore made judgements about both

individual components and the overall WACC. Those judgements

have been set out in this document and previous consultations in this

review.

7.19 The discussion in the previous chapters supports the CAA's view that,

other than the top of the TMR range, the range for the WACC that was

presented in the final proposals remains the appropriate range.


January 2014 52

Figure 7.1: Summary of CAA's range

HAL GAL

% final

proposals

range

Final view

point estimate

final

proposals

range

Final view

point estimate

Gearing 60 60 55 55

Pre-tax cost of debt 2.78 - 3.45 3.20 2.95 - 3.58 3.20

Total market return31

6.25 - 6.75 6.25 6.25 - 6.75 6.25

Risk-free rate 0.50 - 1.00 0.50 0.50 - 1.00 0.50

Equity risk premium 5.75 5.75 5.75 5.75

Asset beta (number) 0.42 - 0.52 0.50 0.46 - 0.58 0.56

Equity beta (number) 0.90 - 1.15 1.10 0.90 - 1.17 1.13

Post-tax cost of equity 5.68 - 7.61 6.84 5.68 - 7.71 6.99

Tax rate 20.2 20.2 20.2 20.2

Pre-tax cost of equity 7.11 - 9.54 8.58 7.11 - 9.66 8.76

Pre-tax WACC 4.51 - 5.89 5.35 4.82 - 6.31 5.70

Vanilla WACC 3.94 - 5.12 4.66 4.18 - 5.44 4.90

Source CAA analysis

7.20 Combining all the point estimates of the components set out in the

preceding chapters, the pre-tax WACC is 5.35% for HAL and 5.7% for

GAL.

7.21 Compared to the final proposals, the CAA has made one adjustment

to reduce the TMR by 50bps. This adjustment reduces the pre-tax

WACC for both HAL and GAL by 25bps.

7.22 The CAA's point estimate for HAL represents the 61st percentile in the

range. The CAA's point estimate for GAL represents the 59th

percentile in the range.

31

The TMR range stated is that based on PwC's advice. As noted in chapter 6, the CC suggests

that the TMR is not above 6.5%. For consistency the range in the table is the same as set out

in the final proposals.


January 2014 53

The equivalent percentiles in the final proposals were 79th

percentile (HAL) and 76th percentile (GAL).

The equivalent percentiles for Q5 were 77th percentile (HAL) and

75th percentile (GAL).32

The CAA notes that the CC point estimate for its NIE vanilla WACC

represented the 55th percentile of its initial range.

7.23 The CAA considers that the point estimates from the range better

reflect the ARR and place the appropriate emphasis on the

asymmetric consequences of getting the WACC wrong without undue

weight. The CAA considers that its conclusions address the airlines

concerns in this respect.

Figure 7.2: Comparison of final views to Q5 decision

% HAL HAL GAL GAL

Q5 decision - headline WACC 6.20 6.50

Q5 decision - ARR (effective WACC) 6.01 6.30

Reduction in Corporation Tax (0.40) (0.40) (0.43) (0.43)

Reduction in cost of debt *(0.20) (0.17) *(0.20) (0.17)

Reduction in GAL gearing n/a n/a 0.08 0.08

Reduction in cost of equity *(0.25) (0.09) *(0.25) (0.09)

Q6 final views 5.35 5.35 5.70 5.70

The effect of the ARR is included in the estimates of the changes in these components

Source: CAA analysis

7.24 The comparison to Q5 is complicated because the headline WACC of

6.2% (HAL) and 6.5% (GAL) was not applied to the RAB to calculate

the price cap. Instead a lower rate, also called the ARR, of 6.01%

(HAL) and 6.3% (GAL) was applied. Compared to the Q5 ARR, the

Q6 final views are 66bps lower for HAL and 60bps lower for GAL.

7.25 Figure 7.2 shows how the CAA's final view relates to Q5. Focussing

on the comparison of the effective Q5 WACC with the Q6 final views,

the reduction in WACC is due to:

reduction in corporate tax rates (c40bps);

32

The Q5 comparative percentiles are calculated on the basis of the ARR's of 6.01% (HAL) and

6.3% (GAL).


January 2014 54

reduction in the cost of debt due to lower market yields (17bps);

a reduction in the cost of equity and specifically the TMR

assumption (9bps); and

for GAL the reduction in gearing (8bps increase in the WACC).

Comparison to other sectors

7.26 The CAA's final views for a pre-tax WACC of HAL and GAL are 5.35%

and 5.70% respectively. These translate into vanilla WACCs of 4.66%

and 4.90% respectively. The CAA has calculated the appropriate

values for the comparators to its final views.

7.27 In the following table, WACCs from other sectors are presented. To

facilitate the comparison

the WACCs are on a 'vanilla' basis (ie excluding taxation); and

where the regulator uses the ARR (NERL and CC in respect of

NIE), or equivalent adjustments (Ofgem and ORR) the values

shown in the table have been adjusted to reflect the effective rate

applied to a simple average of opening and closing RAB.

Therefore the values in the table may differ to the 'headline'

WACCs quoted in other sectors.


January 2014 55

Figure 7.3: Comparison of CAA's final views to other regulated sectors'

vanilla, adjusted WACCs

Regulator Sector Status Date of

decision

Appropriate

comparative

Ofwat Wholesale water Business plans 2013 4.00-4.50%

Ofgem WDP - Elect Dist Fast-track business

plan

2013 4.02%

CC Northern Ireland Elect. Prov. Determination 2013 4.02%

Ofgem Gas Distribution Determination 2012 4.11%

ORR Network Rail Determination 2013 4.22%

Ofgem Gas Transmission Determination 2012 4.30%

Ofgem Elect. Trans., National Grid Determination 2012 4.45%

Ofgem Electricity Distribution Determination 2009 4.59%

Ofcom MCT Determination 2011 4.60%

CAA HAL Final View 2014 4.66%

Ofgem Elect. Trans., Scottish Determination 2012 4.68%

Ofcom Openreach View 2013 4.90%

CAA GAL Final View 2014 4.90%

Ofwat WASC Determination 2010 5.10%

CAA NERL Determination 2010 5.54%

Ofcom Rest of BT (not price

controlled)

View 2013 5.70%

Note Ofgem: This is the lower figure after an adjustment is made by Ofgem equivalent to the ARR. In the

excel models used by Ofgem to calculate the price controls, the closing RAB each year is discounted by

the WACC, before applying the WACC to the simple average of the opening and adjusted closing RAB.

Ofgem describe this as the NPV-neutral RAB base. For example see rows 13 to 32 of the RAV&Return

sheet found at the following link http://www.ofgem.gov.uk/Networks/Trans/PriceControls/RIIO-

T1/ConRes/Documents1/RIIO_ET1_FP_FinancialModel_dec12.xlsm.

Note CC: Although not explicitly stated in the CC's Provisional Determination, it appears that the CC did

use the ARR as noted in one of the responses to the Provisional findings. http://www.competition-

commission.org.uk/assets/competitioncommission/docs/2013/northern-ireland-electricity-price-

determination/hastings.pdf

Note: ORR: The value shown is the semi annual WACC used by ORR which is the same as the ARR

Note CAA NERL: This is the vanilla ARR.

Source: CAA Analysis

http://www.ofgem.gov.uk/Networks/Trans/PriceControls/RIIO-T1/ConRes/Documents1/RIIO_ET1_FP_FinancialModel_dec12.xlsm

http://www.ofgem.gov.uk/Networks/Trans/PriceControls/RIIO-T1/ConRes/Documents1/RIIO_ET1_FP_FinancialModel_dec12.xlsm

http://www.competition-commission.org.uk/assets/competitioncommission/docs/2013/northern-ireland-electricity-price-determination/hastings.pdf




January 2014 56

7.28 In addition to the CC's NIE provisional determination, the general

direction of regulatory decisions and/or views continues to support the

view that the WACC has reduced over recent years.

7.29 In November 2013, Ofgem assessed the Electricity Distribution plans

against a cost of equity (6.3%), rather than a WACC because the cost

of debt calculated by its indexation model is exogenous to the plans

and assessment. The latest value calculated by Ofgem's indexation

model for the cost of debt is 2.72% and combining this with the cost of

equity of 6.3% and gearing of 65% equates to a headline WACC of

4.0% (equivalent to an ARR of 3.9%). The fast-tracked business plan

of Western Power Distribution (WPD) used a vanilla WACC of 4.1%

(equivalent to an ARR: 4.02%).33

The previous electricity distribution

control period Ofgem used an effective vanilla WACC of 4.59%.

7.30 The values quoted for the 2012 Ofgem decisions include the cost of

debt as calculated by its indexation model at the time of the decision

(2.92%). As noted above, Ofgem's indexation model now calculates

the cost of debt of 2.72%, and if this value was used in the 2012

WACCs they would have been c13bps lower than those quoted in the

table.

7.31 Water and sewerage companies' business plans for PR14 use vanilla

WACCs in the range of 4 - 4.5% and are significantly below Ofwat's

previous decision for PR09 of 5.10%. Although Ofwat has not yet

published a WACC number, comments from Ofwat suggest that the

vanilla WACC is likely to be at the lower end or below the rates used

in the business plans. For example:

In a speech on 13 November 2013 to 'Water 2013' Sonia Brown,

Chief Regulation Officer of Ofwat noted that the 'Cost of capital will

fall [for the next control period compared to the current control

period] - when companies put forward their proposals for the cost of

capital in their business; there is a real opportunity for this number

to start with a 3.’34

33 https://www.ofgem.gov.uk/ofgem-publications/84945/assessmentoftheriio-ed1businessplans.pdf

34 http://www.ofwat.gov.uk/mediacentre/speeches/prs_spe20131113water2013sbrown.pdf

http://www.ofwat.gov.uk/mediacentre/speeches/prs_spe20131113water2013sbrown.pdf


January 2014 57

In an announcement on 19 December 2013 Ofwat stated that

'Ofwat’s initial testing of companies’ views on risk and reward has

shown that they are not in alignment with market evidence for the

water sector'.35

7.32 The ORR's final determination confirmed its draft determination in

respect of the WACC. In its determination the ORR assumed a

headline vanilla WACC of 4.31%. However, it used a lower 'semi-

annual' vanilla WACC of 4.22% to reflect the concept that returns can

be reinvested. (The previous control period vanilla WACC was

4.75%).

7.33 The CAA's work on NERL's price control is on-going and the CAA has

not yet expressed a view on the appropriate WACC for the next

control period (2015 to 2019).

7.34 These examples of regulatory vanilla WACCs suggest that regulators

have or are expect to reduce the vanilla WACC by around 40bps and

100bps (possibly more). While it would be incorrect simply to apply

the reductions seen in other sectors to the Q5 WACC in order to

estimate the Q6 WACC, the CAA's reduction in the vanilla WACC of

25bps for HAL and 21bps36

for GAL is less than that seen in other

sectors.

7.35 The CAA's final view on the WACCs for HAL and GAL is consistent

with all recent evidence from other UK regulated utilities and the

CAA's understanding of the risk and price control design of these

industries.

Acquisition by USS of shareholding in Heathrow

7.36 On 24 October 2013 Universities Superannuation Scheme (USS)

acquired from Ferrovial equity shares which equated to 8.65% of the

share capital of FGP Topco Limited, the holding company which owns

Heathrow Airport Holdings Limited and the ultimate parent company of

HAL.

HAL

7.37 HAL noted that its shareholders have repeatedly stated that the CAA’s

35

http://www.ofwat.gov.uk/mediacentre/ibulletins/prs_ib2813pr14changes 36

For a consistent comparison, the Q5 vanilla WACCs were reduced to the ARR before being

compared to the Q6 vanilla WACCs.

http://www.ofwat.gov.uk/mediacentre/ibulletins/prs_ib2813pr14changes


January 2014 58

proposals on WACC were inadequate. HAL also stated that while the

acquisition by USS was a signal of confidence in the long-term future

of the airport, it could not be read as an indication that the CAA’s final

proposals for Q6 were appropriate.

7.38 HAL also quoted USS that said 'while the CAA’s proposals are very

challenging, USS is investing for the long term. We have confidence

that the right incentives will be set in place to encourage the

investment that Heathrow and the UK need'. HAL noted that as well

as a buyer of shares there was also a seller in that transaction which

crystallised inadequate Q5 returns and that the transaction brought no

new equity to the group.

7.39 HAL considered that it was generally accepted that the cost of capital

of large pension funds like USS was lower than the cost of capital of

other types of investors. On that basis, HAL considered that the recent

transaction could not be regarded as a confirmation that the WACC

proposed by the CAA provides an adequate return to all types of

equity investors.

Heathrow Airline Community

7.40 The Heathrow Airline Community response quoted broker estimates

that the acquisition equated to a premium of 14% to 15% to regulatory

asset value.

7.41 The response also noted that there had been a substantial growth in

demand for regulated inflation-protected assets like HAL, and this had

been the driver for the growth of infrastructure funds and infrastructure

as an asset class. The Heathrow Airline Community noted that:

Preqin (2013) showed that infrastructure assets under management

in unlisted funds doubled from €26bn in 2009 to €54bn in

December 2012 and that these funds currently had €24bn of

committed funds yet to be invested.

European focused unlisted funds have raised €9bn so far in 2013.

There were many and increasing numbers of investors with similar

investment requirements to USS.

The ultimate investors in these assets have similar risk-return

requirements, and would look at HAL as a long-term investment as

USS had.


January 2014 59


7.42 PwC has estimated that USS's acquisition equated to a premium of

10% to the HAL RAB. Other estimates have been in the range 13 to

15%.

7.43 Consistent with the final proposals the CAA sees value in examining

market evidence such as this in the absence of publicly listed and

traded equities. However, as previously noted the CAA is cautious

when placing weight on this evidence.

7.44 The CAA considers that the premium paid by USS suggests that there

are investors who are willing to invest in airport operators such as

HAL at the proposed price cap (including the WACC assumption) set

out in the initial and final proposals (regardless of whether or not USS

is investing in HAL for the long term). The USS acquisition and HAL's

ability to issue long-dated debt at market rates shortly after the CAA's

final proposals supports the CAA's views that the price cap proposals

are financeable for HAL.

7.45 The CAA notes HAL's views that the cost of capital for pension funds

such as USS is lower than other types of investors. However, the

CAA has assessed the risk and, therefore, the appropriate return for

HAL independently of its ownership.37

Different investors may have

different risk/return preferences, but this does not alter the risk of the

underlying asset (HAL). In fact, USS's investment confirms HAL is a

low risk asset because it is attractive to those investors seeking such

assets (and, by definition, requiring lower returns).

Overall conclusion

7.46 While the CAA has built up its estimates of the WACC by assessing

individual components it has also assessed the overall WACC by

comparing it to other sectors, understanding where in the range of the

WACC the point estimate is and understanding recent corporate

finance transactions involving HAL and GAL.

7.47 There is no single correct answer for the value of the WACC. The

CAA considers that its point estimate for the WACC is within a

plausible and reasonable range. The CAA acknowledges that there

are arguments to suggest that the appropriate value for individual

components may be higher or lower than the point estimates for 37

This approach is common across regulators.


January 2014 60

individual components chosen by the CAA, but that in the round the

WACC estimates of 5.35% for HAL and 5.7% for GAL appropriately

balance these arguments.